The European Debt Crisis

Joseph Foudy Department of Economics jfoudy@stern.nyu.edu

Copyright : Joseph Foudy 2011 (charts and illustrations copyrighted by original sources)

The European Debt Crisis

1. Europes Debt Problem 2. The nature of the Euro and the challenges to its future 3. A Closer Look at Greece 4. The Threat of Contagion 5. Crisis and the Global Economy

1. Europes Debt Problem

Debts and Deficits

Source: http://seekingalpha.com/article/205457-the-u-s-worse-off-than-greece

1. Europes Debt Problem

Debts and Deficits

Source: http://seekingalpha.com/article/205457-the-u-s-worse-off-than-greece

1. Europes Debt Problem

Debt as Percent of GDP (2000)

Source: http://www.ritholtz.com/blog/2010/05/chang es-in-european-debt-2000-09/

1. Europes Debt Problem

Debt as Percent of GDP (2009)

Source: http://www.ritholtz.com/blog/2010/05/chang es-in-european-debt-2000-09/

Deficits and Debt Together

Italy has high debt, but lower deficits; Spain low debt, but high deficits

Bad

Good

European Debt

Normally countries can grow their way out of debt But Europe is aging, labor markets are rigid and growth above 2-3% a year is difficult Europe is just not projected to grow in future Hard for weaker countries (PIGS) to get out of date, unwillingness of other countries to bail them

Europe facing Ratings Downgrades

Ratings as of August 2011

Europe facing Ratings Downgrades

Hitting both banks and states

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European Response

Resistance of core European countries (especially German) to bail out weaker states EU has been making incremental measures (too little, too late) since start of crisis

This has meant each attempt to solve the crisis fails Critics argue stronger, bolder action early would have prevented larger crisis and cost less money

Even so, this is a solvency issue for Greece (e.g. it just can not pay this debt) versus other countries where it is arguably a liquidity issue (e.g. short-term crisis of confidence)
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2. The Euro

Nature of the Euro Advantages and Problems of a Fixed Exchange Rate System Lack of Fiscal Union Accession Rules

Fiscal Union

Creating the Euro led to two concerns (known at the time)

First was that you can have only one interest rate, but economies were quite different and movement of people/payments between states was low Second, if one state becomes particularly indebted it would put pressure on the Euro zone to bail them out

Entry criteria were meant to mitigate these issues, but they remained

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US Example

US has same concerns on differing economic conditions

When Florida is booming and Michigan is in recession, what can we do. But in US, people can move states and government transfer payments help

Heavy indebtedness of one state is also a potential concern (though US state budgets are a smaller percent of GDP)

New York City in the 1970s California today

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Role of ECB vs. Fed

In Crisis, Federal Reserve is the lender of last resort

Infused massive amounts of cash into banking system in 2008, bought debt to prop up banks, took unconventional measures like quantitative easing

In Europe, European Central Bank (ECB) has mandate of price stability and has resisted any steps to take on debt

Been forced by member states to take on some Greek debt (will be lose to ECB)

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NYC in 1970s

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1980s were not much better

(now NYU students complain about the number of free cable channels in dorms)
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New York and California Today

Massachusetts and New York debt levels are high in per capita terms, California debt high in absolute terms (but what percent of GDP is $4,800. (US state debts small compared to countries)

Accession/Entry Rules

Euro had strict entry criteria

Inflation must be no higher than 1.5% of average of best three states. Must maintain exchange rates for two years prior. Interest Rates on Long-term Government Bonds must be no higher than 2% of average of best three states. Budget deficit can be no more than 3% of GDP, Govt debt 60% of GDP.

But Greece and Italy fudged the deficit numbers with the help of major investment banks
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Debt as Percent of GDP (2011 and 2013)

Source: http://www.sta.ethz.ch/Strategic-Trends2011/Power-shifts-Emerging-marketsemerged-geopolitics-fractured

3. Greece

Austerity measures immensely unpopular, Greece is reducing deficit but not fast enough Greece has a serious problem collecting taxes 1/3 of Greek Debt has to be rolled over in next year We have perhaps 2 weeks to bail out Greece, force a haircut on borrowers or let it just default

Austerity in Greece

Cost of Greek Debt

Question: Would you buy it at 26% interest?

Austerity in Greece

Austerity has been a core demand of EU and IMF but it is pushing country in recession

Focus has been on across the board wage cuts for public workers and pensioners rather than layoffs Even with austerity, deficit is 10% of GDP

Large tensions between German taxpayers that do not want to bail out Greece and Greeks resentful of cuts

But spending no longer sustainable

Tax Avoidance in Greece

Black economy could be 1/4 or 1/3 of GDP. Tax collection extremely low. 11 Million People and only 5,000 declare incomes over 100,000 Euros

Data from Nicholas Economides, NYU Stern

Greek Sovereign Bonds: 284.2

ECB (bought in open market) Greek banks (held as collateral by the ECB) Greek pension funds and insurance comp. French banks German banks UK banks Portuguese banks US banks Dutch banks Italian banks Austrian banks Swiss banks Belgian banks Japanese banks Spanish banks Others (insurance, hedge funds)

55.0 40.0 30.0 56.9 28.3 14.7 10.2 8.7 5.2 4.5 3.3 3.0 2.0 1.3 1.1 20.0

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3. Greece

Options:

EU lends more money without fixing situation EU arranges a major hair cut of Greek debt holders
Old debt is exchange for new bonds due 10-30 years from now and with debt cut 50-60%, some kind of broader EU guarantee of debt is needed Eurobonds or ECB would have to guarantee debt

Greece defaults and stays in Euro Greece defaults and leave Euro

3. Greece

Problems with leaving the Euro Zone

Reintroduced Drachma would lose a great deal of value Greece has no competitive sectors and imports virtually all its good, which would become much more expensive Greece lacks the short term money to pay its civil servants

Problems with Haircut with Guarantee Option

If European banks take a haircut on Greek debt they will need to be recapitalized by the government. Bailing out banks only slightly more popular with public in Germany than bailing out Greece. In France, government aid to banks might cost it Frances AAA credit rating.

4. The Threat of Contagion

Even France appears vulnerable

4. The Threat of Contagion

CDS spreads in Europe

4. The Threat of Contagion

Look at the VIX

4. The Threat of Contagion

Whatever the resolution of Greece, speculators must now wonder which country would be next to default or arrange a haircut Investors will refuse to buy their debt or demand unsustainably high interest rates Hedge funds will buy bet on default with CDSs creating system risk

4. The Threat of Contagion

Global Debt Issuance Looks Something Like this

Contagion to other PIIGS, France

Greece is a small part of European economy and even Greek debt is manageable

But if a Greek default or haircut creates a run on other countries, other countries to large to save.

4. The Threat of Contagion

Global Interconnected Banking System (public and shadow)

4. The Threat of Contagion

European Banks Facing Funding Problems

Fear of lending to them growing

5. Crisis and Macro-economy

Crisis is weighing not only on Europe but on US Story this summer in US was about how debt standoff in Washington hurt economy

Problems in Greece probably a bigger factor

Even if we avoid a Lehman-like market meltdown, this crisis could be the straw that breaks the camels back and puts us into double dip

Questions?